Bond Insurer Break-up vs. Super SIV - Beware Unintended Consequences
All this talk of a government-driven break-up of bond insurers into their municipal and non-municipal (read: structured mortgage securities) components leaves me scratching my head. Why are so few calling bullsh*t on New York State insurance superintendent Mr. Dinallo and his strong-armed tactics? This is not the government urging a solution, this is more akin to the government holding a gun to the head of bond insurers and saying “Restructure - or else…” And it is just not that simple due to the complex webs of financing arrangements among the bond insurers, the banks and the buyers and sellers of credit protection on both the firms themselves and the securities they’ve backed. His actions may well have unintended consequences that far exceed any benefits that might be created, largely by calming down issuers of and investors in municipal debt obligations.
But given the low historical default rates on such paper, are all of these financial machinations really worthwhile? There is much data to argue that the municipal bond insurance industry shouldn’t exist to begin with, given these default rates. If municipalities have to issue at slightly higher rates in the absence of insurance, isn’t this a cleaner long-run way to fund itself? As we all know buying insurance is an NPV-negative enterprise for the buyer; all is is really doing is taking unwanted “tail risk” off the table. But can’t we withstand a few defaults in order to strip the friction of insurance out of the industry? All this money paid out to bond insurers over the last 30 years is largely a tax on issuing bonds that don’t really need the enhancement to begin with. So what’s all the fuss?
While the discussion around the a good bank/bad bank approach to the structured investment vehicle (SIV) problem of the banks was largely negative, it was a far more straight-forward, market-driven solution to a difficult problem than Mr. Dinallo’s urgings. And as the Super-SIV approach became more real, the banks decided to take care of the problem themselves. A win/win without paying the frictional costs of establishing such a structure. Mr. Dinallo’s solution would be maximally disruptive for a minimum of benefits. Maybe I’m just missing it.
But I can see the government-driven bond insurance restructuring program getting mired in a protracted court battle among entrenched interests on all sides. But instead of simply reporting on the bond insurance industry break-up I’d like to see some more critical analysis of its cost and benefits. Because taking this step is a big deal and sets a very worrisome precedent. There is urging and facilitation and then there is coercion, and Mr. Dinallo’s steps are falling dangerously close to the latter.
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COMMENT:
AUTHOR: STS
EMAIL: seth_stafford@comcast.net
URL:
DATE: 02/17/2008 02:05:46 PM
Separating the municipal bond insurance operations from the other “innovative” product lines might help to facilitate recapitalization of the two segments because investors will have better “labeling”. Over here, we have the traditional business which is so safe as to be redundant; over there, we have the toxic stew. If you think you’re smart enough to figure that stuff out, have fun! Having the two mixed together probably slows things down. Although anyone in a position to invest directly would have to do this kind of analysis themselves, having a legal structure in place that enforces the distinctions might function as a useful “covenant” on the deal.
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COMMENT:
AUTHOR: dvjm
EMAIL: junk@hotmail.com
URL:
DATE: 02/17/2008 04:00:58 PM
I wouldn’t worry. The contractual law implications will keep the whole thing tied up in the courts for years. There’s no way the stock holders, the debt holders or the insured are going to sit back and let this happen.
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COMMENT:
AUTHOR: mike in LA
EMAIL: mgjovik@msn.com
URL:
DATE: 02/17/2008 09:10:14 PM
dvjm’s point that litigation would prevent a “good bank /bad bank” break up ignores the role that Federal legislation could play. Congress’s final words to Dinallo after last week’s hearings were “take care of the munis.” All it takes is a stroke of the pen from Congress and all those pesky lawsuits are toast. Remember, ”grassroots politics” is just a fancy word for all the support municipal politicians give their elected repesentatives in Washington. There isn’t a soul in Congress who will stand by while every city, town and burb in his district gets downgraded. AMBAC, FGIC and MBIA are calving, even if they don’t yet know it..
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COMMENT:
AUTHOR: Brian
EMAIL: equityval@yahoo.com
URL: http://www.tgadgets.vox.com
DATE: 02/17/2008 09:57:03 PM
I agree this is coercive - it is classic Spitzer behavior. The risk vs benefits question that you raise is a hard to resolve.
First on the question of the value of the insurance, I agree that for large well known issuers, ie the states, the Port Authority of NY/NJ, there is little value to the insurance. For smaller issuers, there is value in the homogenization of the market and the avoided expense of getting an underlying rating, so I don’t think that assuming life would be the same in muniland without the monolines is valid. Moreover, we seem to be getting a pretty strong signal from the auction rate market that the AAA guarantee has some value from an investor perspective.
I think the most important argument for a split is that this is a way to create a firebreak between what should be highly distinct elements of the capital markets: munis on the one hand and mortgage related securitizations and CDOs. The monolines are the mechanism for contagion between the two markets. Putting aside the issue of equity for the various stakeholders, putting the muni guarantees in a distinct entity makes a lot of sense from the standpoint of not infecting yet another market with the structured finance virus.
The legalities of whether this is feasible or defensible probably turn on the details of the contracts written on the structured finance side and what kind of guarantees or backstops the entities farther up the family tree provided to the structured finance side. I believe the structured finance contracts were written by the “extender” entities, so perhpas there is a legal basis to split the baby.
Beyond the legality of a split, I can imagine a scenario in which the structured finance holders are better served by a split. If FGIC/Ambac arrange the split so that the structured finance policy holders get the equity in the muni newco (less whatever equity has to be given to new investors to properly capitalize muni newco) that may be the best way to grow/preserve capital for the structured finance claims (under the assumption that the muni newco equity is monetized at some point down the road). Implicit in this of course is a wipe out, or severe dilution, of the current equity holders in the monolines as they are currently configured. Essentially, this is like some of the asbestos trusts where the equity value of the company involved was used to set up a fund to pay claims. Doing something like this may be a way to avoid years of litigation, and let’s face it, at this point there are no investors for the structured finance book so this is probably their only hope to see some kind of robust claims paying capability in the monolines.
I think the distinction between this and the SIV situation is significant in a few ways. The most important of those is culpability, in a sense.
The SIV “crisis” was something that the banks brought on themselves by setting up flimsy structures and investing in dubious assets from which the collected fees. So it was appropriate for them to bear the cost of cleaning it up.
In the monoline situation, the muni issuers and their investors didn’t sign up for mortgage market/structured finance risk. To effectively ask them to sign on to become economic contributors to a solution for the structured finance policy holders by diluting the value of their insurance contracts doesn’t seem reasonable, and as I said above, it makes no sense to me to infect an unrelated sector with the mortgage virus.
The cost of the precedent of this kind of regulatory behavior is harder to measure as is the cost of the fallout in the banking system. However, the banks brought the mortgage mess upon themselves and should have been more circumspect about the risks in the mortgage markets as well as the ability of the monolines to backstop all of it. They are reaping what they sowed.
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COMMENT:
AUTHOR: blown cue
EMAIL: blowncue@yahoo.com
URL:
DATE: 02/17/2008 10:57:25 PM
David Merkel at Aleph Blog is on it. Money quote:
“Who wouldnít want the option of splitting his business in two during a crisis, putting the good business into subsidiary A, which will stay solvent (and protect some of your net worth) and putting the bad business into subsidiary B, which will go insolvent, and pay little to creditors?
In many other situations this would be called fraudulent conveyance, but when you have a state government behind you, I guess it gets called public policy. The NY Insurance Department tries to sidestep a big insolvency by creating favored classes of insureds.”
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COMMENT:
AUTHOR: Mike in LA
EMAIL: mgjovik@msn.com
URL:
DATE: 02/20/2008 01:56:15 AM
Isn’t the gun in Spitzer’s holster the statutory authority granted to N.Y. state to structure a run off? In other words, if the banks don’t pony up the capital to sustain a AAA rating for the insurers, the insurers get downgraded, and cease to write new business. This forces them into run-off. And that is where the state of New York holds all the cards, because they have have the statutory power in a run off to sequester the muni premiums [as they are realized] to protect the muni book exclusively. So all this talk of litigation to stop a good bank/bad bank settlement is essentially moot, because it happens legally in a run off anyway, which is inevitable following a downgrade.
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2 years ago
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